A radical rethink of the financial system was essential after a devastating crisis

Martin Wolf

A radical rethink of how the financial system works was, one might have thought, essential after the devastating crisis of a decade ago. Instead, the system was patched up. Now, predictably, the mood is shifting towards removing much of the regulation. That is why I hope, despite the polls, that the Swiss vote in favour of the Vollgeld proposal in the referendum on June 10. Finance needs change. For that, it needs experiments. According to a database compiled at the IMF, 147 individual national banking crises occurred between 1970 and 2011. These crises afflicted small and poor countries like Guinea, and big and rich ones, like the US. They were colossally expensive, in terms of lost output, increased public debt and, not least, political credibility. Within just three years from 2007, cumulative output losses, relative to trend, were 31 per cent of gross domestic product in the US. In the UK, the recent crisis imposed a fiscal cost only exceeded by the Napoleonic war and the two world wars. (See charts.)So how does this industry create mayhem on this scale? And why is it allowed to do so? It does so — and is allowed to do so — because, as the Bank of England has explained, banks create money, which is an essential public good, as a byproduct of their lending, which is an important economic good. We want banks to have risky assets and safe liabilities. Yet the liabilities of a highly leveraged, risk-taking institution cannot be safe and will unavoidably seem least safe during a crisis. Yet it is then that people want their money — their reserve of purchasing power in a frightening world — to be at its safest. Worse, it is often easiest for banks to justify lending more just when they should lend less, because lending creates credit booms and asset-price bubbles, notably in property. The willingness of the public to treat bank liabilities as stores of safe purchasing power provides stable funding, until panic sets in. To reduce the likelihood of panic, governments insure bank deposits, liquidity and even solvency. That makes crises rarer, but bigger. The authorities are simultaneously supporting banks and reining in the excesses created by support. This is a system designed to fail.Today, banks are less leveraged and better supervised than before the crisis. In the UK, retail banking is also ringfenced. Yet, the banks are leveraged at about 20 to 1: if the value of their assets falls by 5 per cent or more, such a bank becomes insolvent. One way to make banks safer then would be to increase their equity capital four or five times, as recommended by Anat Admati and Martin Hellwig in The Bankers’ New Clothes.An alternative way to make the system safer is to strip banks of the power to create money, by turning their liquid deposits into “state” or “sovereign” money. That is the idea backed by the Vollgeld initiative. An alternative way of achieving the same outcome would be via 100 per cent backing of deposits by claims on the central bank — an idea proposed by free-market Chicago School economists in the 1930s. The rest of the financial system would then consist mainly of investment banking and mutual funds. The latter shift risk on to the investors automatically. The former might need to be regulated, but mainly on capital.The shift to a system like this would, as Thomas Jordan of the Swiss National Bank argues, be a mini-earthquake. Moreover, the proposal raises questions about the purposes to which the new sovereign money might be used. The obvious possibility is to use the money to finance the government. This idea is highly objectionable to some: it would surely create big challenges. Yet those challenges are nothing like as fundamental as was transferring responsibility for a core attribute of the state — the creation of sound money — to a favoured set of profit-seeking private businesses, co-ordinated by a price-setting government institution, the central bank. In no other economic area is public power so mixed with private interests. Familiarity with this arrangement cannot make it less undesirable. Nor can familiarity with its performance.There are many other ideas in this broad area that seem worth pursuing. One would be to allow every citizen to hold an account directly at the central bank. The technological reasons for branch banking are, after all, perishing quickly. Nicholas Gruen, an Australian economist, has argued that no private institution should have better access to the public’s central bank than the public itself does. Furthermore, he adds, the central bank could operate monetary policy by lending freely against safe mortgages. The central bank would not need to lend to banks per se at all. It would focus on assets.The fundamental point here is that the burden of proof should not be on those who favour change. After a long series of huge and destructive crises, it falls rather on those who support the status quo, even today’s modified status quo. The advantage of the Vollgeld proposal is that it is a credible experiment in the direction of separating the safety rightly demanded of money from the risk-bearing expected of private banks. With money unambiguously safe, it would be far easier to let risk-taking institutions bear the full consequences of their failures. To the extent that bankruptcy remained difficult, regulation would still be needed, especially of equity capital. At the limit, as some argue, risk-bearing financial intermediation might need to be ended.The Vollgeld proposal is not as radical as this. Yet it could provide an illuminating test of a better possible future for what has long been the world’s most perilous industry. May the Swiss dare.

Now, that was a bond rout.One week ago, concerns that Italy would leave the euro zone caused yields on its two-year notes to surge as high as 2.7%, as investors fled its bond markets for safer assets. The yield had been negative just two weeks earlier. (Bond prices and yields move in the opposite direction.)And no wonder. The chances of Italy ditching the euro zone increased—putting the stability of its bond market in jeopardy—after President Sergio Mattarella vetoed the two anti-establishment parties’ choice for finance minister. But investors had been shying away from Italy’s bonds even before last week’s crisis—and though things have stabilized since then, many questions remain.

It would be easy to assume the panic that gripped Italy’s bond market was specific to the country’s political precariousness. But maybe not. Technical evidence suggests that a reckoning may be coming for all risky bonds, according to the Andrew Addison of research firm the Institutional View. If he’s right, Italy may just be the beginning. The spike in Italy’s bond yield didn’t come out of nowhere, though it certainly seemed that way for the two-year note. The yield on Italy’s 10-year bonds had been rising steadily since finding support around 1% twice between 2015 and 2017—creating what is known as a “double bottom,” in technical parlance—and establishing a range between 1.04% on the downside and 2.39% on the upside.That range finally broke on May 21, just six days before Mattarella’s veto.A breakout like this suggests there could be more room for yields to rise. Addison projects Italy’s 10-year yields should reach 4% (a consistent support level tested many times over the past 20 years) and may even reach 4.5% (nearly doubling the old resistance level of 2.4%) by the end of the year.

Investors might be expected to demand higher yields from Italy’s bonds due to the perception that they’re more dangerous than they were two weeks ago. But there is evidence that the investors are beginning to prefer safer bonds across Europe as well.The spread between high-quality European bonds—as represented by the Iboxx Euro Non-Financials AA Total Return Index—and lower-quality ones—as represented by the Iboxx Euro Non-Financials BBB Total Return Index—has been dropping for over two years. Since April, the gap between the values of the two benchmarks has been narrowing, and now sits at -10.52 points as of last Friday, up from -11.85 points in April.It’s a sign that investors now view higher-quality bonds more favorably, which could mean the beginning of a “risk-off” period, Addison says.

And not just in Europe. Investors have begun shying away from global high-yield bonds as well. During the past four months, the Bloomberg Barclays Global High Yield Total Return Index, which includes 34,000 high-yield bonds in the U.S., Europe, and emerging markets, has dropped 3.5% to 1281.8 as of last Friday, its lowest level since last August.The damage looks even worse in chart form. The Bloomberg High Yield Index had been in an uptrend for about two years, but the recent decline formed a “rounding top”—represented by an upside-down “U” shape in the chart—breaking that trend and suggesting more downside to come.

When the market’s riskiest bonds start to dip, it can be an early sign of a weakening economy, even a possible recession, Addison says. We’re not saying we’re there yet, but it’s something to keep an eye on.

By all accounts, Spain should be a European success story. As recently as 2012, the country was teetering on the edge of economic meltdown. Its economy contracted by 3 percent that year. Unemployment climbed to over 20 percent, on its way to a staggering 27 percent by the following year. A banking sector collapse was averted only by a 51 billion euro ($60 billion) bailout package from the European Stability Mechanism that June. There was real fear in Europe that Spain might be the next Greece.

That fear turned out to be misplaced. Over the past three years, gross domestic product growth has averaged over 3 percent. Unemployment has dropped to 17 percent and is projected to fall below 14 percent next year. The European Commission reported that wage growth in Spain is expected to rise faster than inflation in 2019 – so not only are more people finding jobs, but they are getting paid more as well. The government succeeded in pulling Spain back from the brink, and according to the Bank of Spain, it cost the country itself only 26.3 billion euros – not a bad deal considering that its economy is the fourth-largest in Europe and only slightly smaller than Russia’s.

Yet, despite Spain’s much improved economic position, Spanish politics are more unstable now than they have been in decades. With a government plagued by a corruption scandal for years, Mariano Rajoy, who had served as prime minister since 2011, was ousted in a no-confidence vote last week – the first Spanish head of state to have lost such a vote since the 1978 constitution was adopted. Rajoy will be replaced by Pedro Sanchez, head of the Socialist Party, which holds only 84 of 350 seats in parliament and has already promised to call early elections. Spain now joins Italy, France, Germany and the United Kingdom as the latest European country with an extremely weak government.

This isn’t the way things are supposed to work. Economic recoveries don’t usually result in political upheavals. But that is indeed what has happened in Spain. In addition to the prime minister’s ousting, the issue of Catalan independence remains unresolved. The day after Rajoy’s deposal, Quim Torra was sworn in as Catalan president – the first since Rajoy dissolved the Catalan regional government last October and instituted direct rule after an independence referendum that Madrid declared illegal but proceeded anyway. Rajoy’s heavy-handed approach to Catalonia apparently hasn’t dented its desire for sovereignty. During his swearing-in ceremony, Torra committed to creating an independent Catalan republic.

A similar scenario has played out across Europe. All headline economic statistics throughout the EU are trending upward, exceeding even the most optimistic projections of a few years ago. But the moderate economic recovery has been accompanied by increasingly unstable politics. In Germany, the anti-establishment party Alternative for Germany is now the third-largest political party. In Italy, a hodgepodge of euroskeptic, anti-establishment parties have formed a coalition to lead the new government. And in France, if the National Front had a leader with a surname other than “Le Pen,” it may well have prevailed in last year’s elections.

Spain is part of this European trend – and it’s not just because of Rajoy’s fall from grace or Catalonia’s irascibility. It is part of a larger degradation of what has been until now Spain’s predominantly two-party political system. A recent poll by Spanish newspaper El Pais showed that if elections were held today, the top two vote-getters would be anti-establishment parties: Ciudadanos (29.1 percent) and an electoral alliance led by Podemos (19.8 percent). Rajoy’s Popular Party and Sanchez’s Socialist Party – the only two parties in Spain that have formed governments since 1982 – would come in third and fourth place, respectively.

Podemos supports left-wing economic policies, including increased state control over the economy and government services, but it’s also a nationalist party. Ciudadanos, the current frontrunner by a wide margin, may be anti-establishment but it’s not anti-EU. It has combined Spanish nationalism with pro-EU and classical liberal policies like lower taxes and free trade. It’s comparable to French President Emmanuel Macron’s En Marche party, and indeed, the two parties have even reportedly been in touch recently, offering hope to Europhiles that out of this weekend’s chaos might come a Spanish government supportive of French and German proposals to reform the EU by giving Brussels expanded powers.

But for Spain, unlike Germany and France, this is all complicated by the fact that what is at stake is not just the status of the European Union but the future of a unified Spain itself. Ironically, Ciudadanos began as a Catalan political party – its headquarters are still in Barcelona. And yet, Ciudadanos has taken a harsh line on the issue of Catalan separatism, pushing instead for a more tightly knit Spanish nation-state. Podemos, headquartered in Madrid, has thus far presented itself as more accommodating than either the outgoing Spanish government or Ciudadanos when it comes to Catalonia’s independence movement. That makes some sense. It would appear hypocritical for Podemos to support anti-EU sentiment in Spain and then reject nationalist sentiments in Catalonia.

In Spain, the primary (but by no means only) division is between the country’s leading GDP contributor, Catalonia, and its second-largest contributor, Madrid. This is a riddle no Spanish political entity has ever really solved. Even at the height of the Spanish Empire’s power in the 1640s – when Spanish armies outnumbered the combined military manpower of France, England and Sweden – Spain was in danger of tearing itself apart. Catalonia, along with Aragon and Valencia, had its own independent legal and tax systems at the time, and it even revolted against the crown when Madrid tried to integrate Catalonia’s economy into the empire.

During those days, it was the Castile region, with its capital moved to Madrid by Phillip II in 1561, that held the fractious kingdom together, both with its soldiers and with its money. And though Spain has had its fair share of instability since the empire fell, Castile has always been the force that kept Spain together, whether by war, dictatorship or, most recently, constitutional arrangement. Catalonia has at times opposed this, but never wholly and never successfully. Even so, the 2008 financial crisis stirred up old animosities because a passionate faction of the Catalan population no longer wanted to send its tax revenue to Madrid – a desire that has not abated even as the Spanish economy has recovered.

Other European countries have been keeping a close eye on developments in Catalonia. In some parts of Europe, particularly in the east and the Balkans, the sacrosanctity of borders is sometimes viewed not as a valuable principle in and of itself but as a paltry ideological justification for empowering some at the expense of others. Catalonia may be an internal problem for Spain, but self-determination is an issue that has long plagued the whole continent, even if it has been relatively dormant in recent decades. Disenchantment with establishment politics and the debate over the optimal degree of sovereignty to be ceded to the European Union is not just a Spanish concern but a European problem.

And while all this is happening, keep in mind that, for Spain, this is now what it looks like when things are generally going well. Imagine what it would look like if they weren’t, and you’ll understand how frayed the fabric of Europe has become.

Higher inflation and less central-bank stimulus should equal higher bond yields, right?The answer has been yes in the U.S., but not in Germany, where Italian political turmoil has pushed yields lower, wrong-footing even Bill Gross. A battle that will shape markets is under way between the economic logic forcing German yields higher and the political problems weighing them down.In one way, last week’s blow-up in Italian bonds, which sparked a rush into safer securities, gives the bet on higher German yields even more potential, as the starting point is more extreme. The thesis is simple: The deflation panic has passed, central banks will withdraw monetary stimulus in response to higher inflation, so yields on “safe” assets like Bunds and Treasurys should rise.

The European Central Bank’s chief economist Peter Praet signaled Wednesday that eurozone policymakers would debate a further step back from its bond-buying program next week. That was a surprise to investors who had thought political risk might lead the ECB to slow down.

FOLLOW THE LEADER?Ten-year government bond yieldsSource: WSJ Market Data Group

But while the U.S. market has followed the playbook, with 10-year yields recently reaching a near seven-year high, Germany is still way out of whack on historical measures. Janus Henderson’s Mr. Gross has been expecting the gap between German and U.S. yields to narrow. Instead, it has kept widening to levels not seen in 30 years. 10-year Treasurys are now at 2.95% and Bunds at 0.44%.Meanwhile, relative to domestic inflation, which stands at 2.2%, German yields are at a level seen only once before in 63 years, notes Deutsche Bank . That was early in 2017, when the ECB had yet to signal that it was thinking of starting on the long road to tighter monetary policy.

Bill Gross will need patience and a thick skin for the bet to pay off. Photo: lucy nicholson/Reuters

But the European market is not the U.S. market. As a collection of national markets it has many moving parts with potentially conflicting policies. As Italy has reminded investors, this means politics can trump economics. Counter-intuitively, tighter ECB policy could even depress German yields if the move is seen as contributing to stress elsewhere in the bloc. Eurozone growth will need to be solid to counterbalance that.Ultimately, economic logic should prevail. Investors can’t indefinitely be happy with a negative real return on German bonds. But the likes of Mr. Gross need patience and a thick skin for the bet to pay off.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.